Recently, SEBI asked mutual fund houses to change the manner which they were using to measure the fund performance. They were instructed to consider Total Return Index (TRI) as the new benchmark from 1 February 2018.
Such a move has been aimed to provide the investors with an appropriate benchmark. The Total Return Index (TRI) will give them a true picture of a mutual fund scheme before they actually decide about investing.
Right now all the mutual fund schemes are benchmarked against Price Return Index (PRI). SEBI found this index as highly inadequate in capturing holistic performance of a mutual fund scheme.
Before embarking on the differences, let’s have a look at meaning of a benchmark.
What is a benchmark?
A benchmark, also called as index, is a collection of securities taken at the prevailing market price. The value of the benchmark is equal to sum of the price of its components. When price of its components changes, the price of the benchmark also changes.
The benchmark acts a reference point against which performance of a mutual fund can be compared. If the fund performs better than the benchmark, you may call it outperformed the index.
If the fund performs worse than the benchmark, you may call it under performed the index.
Total Return Index (TRI) vs Price Return Index (PRI)
An investment vehicle like a mutual fund generates returns by two means i.e. capital appreciation and dividend payouts. Capital appreciation relates to the increase or decrease in the market price of the security.
While measuring returns which a security like equity fund actually generated, both of the above components play crucial role. However, until recently, only one of them was considered for gauging performance.
The Price Return Index (PRI), which acted as the benchmark for mutual fund schemes, captured only the capital appreciation aspect of index constituents. It ignored the dividend payment component of mutual fund schemes.
To make things transparent and credible, Total Return Index (TRI) has been introduced. It includes both the capital gains and dividend component to determine returns.
For an identical basket of securities, the return of a total return index will always be greater than that of the price return index. It will be due to the additional payouts by way of dividends.
Thus, sticking only to the price return index might overstate the extent by which the mutual fund scheme outperformed the benchmark. This is going to be misleading.
Additionally, the fund houses have been receiving lot of subscription owing to news of schemes outperforming the benchmark. SEBI’s move at this time seems relevant to prevent the investors from having a wrong impression.
Effect on Mutual Fund Investors
Using Total Return Index (TRI) in place of Price Return Index (PRI) can affect the future investment strategies of the investors. Especially as regards moving from active investing to passive investing.
Historically, large number of actively managed mutual funds have outperformed the benchmark indices over the long term. But as their asset under management grew, the degree of excess return or alpha started shrinking.
If you find that your fund which outperformed the Price Return Index is under performing the Total Return Index, over a period of say 3 to 5 years, it is time to conduct a detailed performance review. In case the situation doesn’t improve, you might have to switch to alternate fund options.
Investors elsewhere are gradually transitioning to passive investing. They are investing in low-cost investment vehicles like index funds and ETFs. You might think of the same to earn better returns.